Should You Buy, Sell, or Hold Nuance Communications?

People have been talking about voice recognition for years, so the concept itself is not particularly new. However, the technology has advanced in recent times and its potential for mainstream usage is a recent development.

Should you buy, sell, or hold voice expert Nuance Communications (Nasdaq: NUAN  ) ?

Buy: Mobile
When it comes to mobile devices such as smartphones and tablets, voice and touch are the new keyboard and mouse. Technological interactions are quickly moving toward these intuitive media as the form factors of today's mobile gadgets demand. Basic voice commands utilizing speech recognition have been around but are more usable now, and Apple (Nasdaq: AAPL  ) is taking it to the next level with its virtual assistant Siri.

While Siri's strength lies in interpretation and intelligence, it does rely on Nuance for its back-end recognition. Before Apple bought Siri, it used technology from rival Vlingo, later making the switch since Nuance is just plain better. It also doesn't hurt that Nuance has "the most IP in speech synthesis technologies in the industry," according to Siri co-founder Norman Winarsky. Oh, and that Vlingo company mentioned a moment ago? Yeah, Nuance just bought it, but more on that later.

The fact that rival tech giants Amazon.com (Nasdaq: AMZN  ) , Google (Nasdaq: GOOG  ) , and Microsoft (Nasdaq: MSFT  ) are similarly focusing heavily on voice should be a testament to the importance of the technology. Amazon quietly picked up a small speech recognition start-up in November, Google followed suit in December, and Microsoft just gave the Xbox ears.

Buy: Smart TVs
It doesn't stop at mobile devices. Voice will soon power one of the least-mobile devices you have: the television. Smart TVs will displace the dumb TVs that preceded them, just like smartphones are replacing dumb phones. The difference is that since TV upgrade cycles are in the neighborhood of seven to eight years, as opposed to the roughly two-year cycles that smartphones see, the transition will take longer.

There's little doubt that Apple's upcoming Apple TV set will feature voice control (likely powered by Siri). Microsoft's Xbox voice integration is also geared toward bringing TV content to the console. Nuance recently announced its new Dragon TV platform that partners with LG to add voice recognition features. There's little doubt that voice interactions with technology will continue to find their ways into our lives.

Sell: If you can't touch it, is it real?
Nuance has picked up a taste for acquiring smaller companies, and they've proven so delicious that the company can't seem to stop gobbling up the little guys. Just a few examples would be the aforementioned Vlingo acquisition, Swype, Equitrac, and SVOX last year, but there are many more.

Organic growth always tops growth by acquisition, partially due to the abstract accounting of goodwill and intangibles. At the end of fiscal 2011, it had almost $3.1 billion on the balance sheet in goodwill and net intangible assets, representing more than 75% of its total assets. Those amortization costs add up, to the tune of $143.3 million last year. That's in addition to the other $21.9 million in acquisition-related costs.

As with any company that relies heavily on acquisitions to drive growth, a major risk lies in how well the buyer can stitch those purchases together in an integrated fashion, and do so in a way that delivers value to shareholders. If those acquisitions don't pan out as well as hoped, that's a lot of goodwill to be written down, and impairment charges can be painful.

Sell: Valuation
Nuance is downright pricey. And this is coming from a guy who likes small-cap growth stocks, a motley bunch notorious for trading at high multiples. Shares currently trade north of 234 times earnings. Fiscal 2011 turned a $38.2 million profit, the first sign of black ink followed by at least five consecutive years of losses.

On top of that, Nuance has accumulated a fair amount of debt. At the close of fiscal 2011, it had $887.4 million in gross debt outstanding, including $145 million in term loans due in March of next year, with another $492 million due three years after that. Also included in that total is $250 million in convertible debentures, which carry a conversion price of $23.36, meaning that holders could potentially force Nuance to redeem them since shares now stand above $28.

Hold: Competition
Nuance's annual report specifically names Microsoft and Google as some of its larger rivals, which are two worthy competitors with deep pockets. Mr. Softy and Big G are currently Nuance customers, but they are developing competing technologies. Having Apple on its side is certainly a blessing, but it's partially offset by the presence of Microsoft and Google on the other side of the equation.

The verdict
Despite the nuances of accounting for acquisitions, Nuance Communications is a buy. The company will play a vital role in how our interactions with technology will evolve, and it has established itself as the clear leader in voice technology.

Much of the net losses generated in recent years can be chalked up to amortization of intangibles. Looking at cash flow, Nuance generated $322.5 million in positive free cash flow last year. It reported a net loss of $19.1 million in fiscal 2010, but behind that figure was $270.3 million in free cash flow.

I'm following up my bullishness with an official outperform CAPScall, since I think Nuance is poised to win. I already have some investments in touchscreen microcontrollers, and I may even add Nuance to my portfolio to round out my voice-and-touch thesis.

The mobile revolution is also set to become "The Next Trillion Dollar Revolution." There are lots of companies that are set to cash in on it, but one in particular has excellent prospects. The company is one of a few players that will help power the mobile devices of the future, and it also has exposure to the explosive growth in China. I've given it an outperform CAPScall. Get access to this 100% free report to find out what company I'm talking about.

Fool contributor Evan Niu owns shares of Apple and Amazon.com, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Apple, Amazon.com, Google, and Microsoft. Motley Fool newsletter services have recommended buying shares of Amazon.com, Nuance Communications, Microsoft, Apple, and Google. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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